But practice doesn’t always live up to theory. There have been two major equity bear markets this millennium. Most traditional balanced portfolios suffered significant declines during the bursting of the dotcom bubble. Gains from holdings in government bonds were insufficient to offset equity losses. Investors responded by diversifying across a broader range of asset classes and strategies. Yet most multi-asset funds suffered similar declines during the global financial crisis.
The decade-long recovery from 2009 lows has provided a different challenge for diversified strategies. Most multi-asset portfolios have lagged equity markets since the last crisis.
Today, bond yields across the developed markets are extremely low by historical standards. They offer little protection to investors if inflation picks up. Equity market valuations appear rich, leaving markets vulnerable when this elongated economic cycle finally comes to an end. This increases the appeal of alternative asset classes. Many offer the potential for attractive returns, driven by different fundamental drivers.
What should investors expect from a diversified multi-asset portfolio? To help answer this question, we look at the successes and failures of multi-asset investing over sixty years. We examine how investment strategy has evolved since the 1952 publication of Markowitz’s landmark paper on Portfolio Selection. We argue there have been three step-changes in diversification strategy: the first driven by globalisation; the next two triggered by the two major bear markets. We look at best practice today – the version 4.0 of our title. And we peer into the future.
The pre-history of diversification
Diversification is as old as finance. Cuneiform tablets discovered in modern Turkey capture the trading activities of merchants from Assur, an ancient Mesopotamian city-state. Around 4,000 years ago, these traders established sophisticated equity trading partnerships that extended over multiple yearsi . These partnerships provided the scale to finance the fixed costs of outfitting and staffing a caravan: donkeys carried textiles on their outward journey and silver on their return. They also allowed investors to diversify their risks by investing in more than one partnership.
The insurance industry dominated institutional investing for 150 years – from its expansion in the early nineteenth century to the middle of the twentieth. Diversification of risk across the pool of policyholders provided the foundations for the industry. Investment strategy focused on minimising risk. This still provided scope for diversification. In the second half of the nineteenth century, insurance companies switched from public to private credit markets in search of higher returnsii.
The First World War ushered in a new inflationary cycle. This brought the need for a different investment strategy. A 1924 publication, Common Stocks as Long Term Investments by economist and investor Edgar Lawrence Smith, highlighted the premium return offered by stocks. A few innovative investors started to invest in equities soon after. This included John Maynard Keynes in his role as chairman of the National Mutual Life Assurance Society.
Diversification 1.0: The 60:40 portfolio
The publication of Portfolio Selection by Harry Markowitz in 1952 ushered in the era of modern portfolio theory. Investors could now quantify portfolio risk. Analysis of risk stood shoulder to shoulder with the analysis of expected returns.
Markowitz’s work provided the mathematical underpinnings for portfolio optimisation. It provided investors with a tool to build portfolios situated on the ‘efficient frontier’ – offering the maximum expected return for the level of risk.
This paper also provided the starting point for Bill Sharpe’s work on the Capital Asset Pricing Model (1964). Sharpe addressed how investors would value assets if they religiously followed Markowitz’s recommendations when constructing portfolios. He introduced the concept of beta, a measure of volatility relative to the market.
The impact of these two papers is still being felt today.
US pension funds used Markowitz’s framework as the starting point for investment strategy. They converged on a mix of 60% equities and 40% bonds. Investors have broadened their horizons to other asset classes, but many still measure themselves against this benchmark.
Taking Sharpe’s thinking to its ultimate conclusion led to the birth of the booming index fund industry.
Diversification 2.0: adventures in equities and bonds
Four trends combined to drive a broadening of investments in the 1980s and 90s;
rapid growth in emerging markets
financial innovation and
The Bretton Woods system of fixed exchange rates ended in 1973. This ushered in an era of currency market volatility. Over the next two decades, countries abandoned the capital controls that had restricted investment flows into overseas markets. Investors responded by increasing exposures to overseas equities.
In 1981, Antoine van Agtmael of the International Finance Corporation coined the phrase ‘emerging markets’. Investors had seen the Japanese stock market perform strongly over three decades of rapid economic development. They saw the ‘Asian Tiger’ economies – Hong Kong, Singapore, Korea and Taiwan – successfully adopt similar industrialisation strategies. The manufacturing industries in the US and Europe struggled to compete as globalisation accelerated. Pension portfolios in the US and Europe were exposed to the struggles of their domestic manufacturing industries. This triggered an asset allocation shift from developed market to emerging market equities.
Strong economic performance in the emerging world also improved debt sustainability. Emerging market debt started to enjoy strong institutional inflows.
Financial innovation in the US led to the creation of three new markets.
The mortgage-backed securities market came into existence in 1968. Ginnie Mae was established by the US government to promote home ownership. They guaranteed the first ‘pass-through security’ of an approved lender, where mortgage payments passed through to the holder of the mortgage-backed security. Today, these securities make up more than a quarter of the Bloomberg Barclays US Aggregate Index of investment-grade bonds.
The high-yield bond market took off in the 1980s. High-yield bonds have always existed. But these were ‘fallen angels’; issued as investment grade but downgraded to ‘junk’ when the issuers ran into trouble. The late 1970s marked the start of the primary issuance of sub-investment grade bonds. A leveraged buyout boom in the 1980s created a steady supply of bonds. Drexel Burnham Lambert, under the leadership of Mike Milken, dominated the market and found ready buyers.
The leveraged loans market developed in the late 1990s. Loan documentation was standardised, allowing a secondary market to evolve. A boom followed in the early years of the new millennium, the next stage of our diversification story.
Academic studies uncovered two styles of investing that attracted significant attention. A 1981 study by Rolf Banz identified the strong historic performance of smaller companies. Investment managers responded by launching a number of dedicated smaller companies funds. In 1993, Eugene Fama and Kenneth French published research on a three-factor model. This included ‘value’ alongside ‘size’ and the ‘market’ factors. US investors started to diversify across value and growth managers.
By the turn of the millennium, investors were diversified across: domestic and international equities; value and growth stocks; large-cap and small-cap; developed and emerging markets; and government, mortgage and corporate bonds.
Yet this mix was still a blend of equities and bonds. This strategy was stress-tested when the technology bubble burst in 2000. Equity and credit markets fell in tandem. Widening credit spreads meant the more diversified fixed income exposures lagged behind government bonds. Compared to the two-asset 60/40 allocation, the more diversified strategy proved more vulnerable to a severe market decline. Correlations between alternative assets increased during times of stress.
Diversification 3.0: the Yale model
One pioneering portfolio manager emerged from the technology bust with a lasting legacy. Under the leadership of David Swensen, the Yale Endowment generated positive returns in both 2001 and 2002. This came on top of strong returns over the previous decade. Investors around the world soon tried to imitate the key differentiating factor of his strategy: exposure to alternative assets.
Yale’s alternative assets fell into three categories: absolute return (or hedge funds); real assets (or property and natural resources); and private equity. Each presented challenges for investors inexperienced in these assets.
Hedge funds and private equity managers often employed complex investment strategies. Their funds were unregulated investment vehicles. Due diligence required specialist knowledge. A fund-of-funds industry grew out of the demand from investors for an expert view. Some of these managers raised ‘permanent capital’ by listing their funds on the London Stock Exchange.
Investing in real assets also proved challenging. The US REITs (real estate investment trusts) market provided one accessible structure. This was replicated in other jurisdictions.
In the UK, investors developed a new approach to pension fund management. Liability-driven investment lowered the risks to pension providers from falling real rates. Better management of liabilities allowed a new approach to asset management too. Diversified growth funds applied the underlying rationale of the Yale model’s approach to liquid markets. In practice, this meant an asset allocation shift out of equities into other growth assets. These funds embraced high-yield bonds, emerging market debt and listed real estate.
Once again, a severe bear market tested the benefits of diversification. The global financial crisis exposed the high correlation of many hedge fund strategies to equities – at least during periods of market stress. Many private market strategies suffered liquidity crises. Commodity prices crashed as the collapse in economic growth slashed demand. The drawdowns experienced by these more diversified multi-asset portfolios once again left investors questioning their diversification strategy.
Diversification 4.0: alpha, beta and beyond
Where does that leave diversification today? Two trends have reshaped strategy over the decade since the financial crisis. First, investors have gained a better understanding of a broader range of asset classes and strategies. This has allowed them to incorporate new asset classes and strategies in their multi-asset portfolios. Second, advances in quantitative techniques has increased the toolkit for both risk management and return generation.
The aftermath of the crisis increased the opportunity for asset class diversification. It created a growing need for capital in markets previously dominated by hedge funds and other specialist investors. Banks were reluctant to lend as regulators pushed them to reduce the leverage of their balance sheets. Asset owners were reluctant to place their investments in expensive and complex hedge fund strategies. That left a gap in the market.
Specialist investors started to offer simpler exposures to alternative forms of credit. These included direct lending and asset-backed securities. The universe of listed vehicles raising capital to invest in specialist lending markets grew. Today, the size of this market is around ?10 billion (or U$13 billion).
The opportunity also increased to gain investment exposure to a range of real assets. The shift in financing from private markets to listed vehicles has improved governance and costs. This has driven an expansion in the universe of vehicles offering exposure to infrastructure assets – now a ?15 billion (U$20 billion) market – and property.
There are also growing opportunities to finance more specialist markets such as insurance-linked securities, healthcare royalties and litigation finance. The underlying drivers of these markets are less sensitive to economic growth than traditional credit portfolios.
Alongside the existing private equity and property companies, investors can now access a broad and deep universe of listed alternatives (see figure 1).
Figure 1. Growth of the London-listed alternative market
Source: Numis, December 2018
New approaches to investment allow investors to diversify by strategy. Mainstream asset managers have adopted a number of the techniques developed by hedge funds. These combine long-only and long-short1 exposures to generate new strategies across a broad range of markets. Some strategies use derivatives to isolate investment opportunities independent of equity and bond markets.
Advances in quantitative techniques provided investors with a better understanding of the underlying drivers of returns and the associated risks. Fund managers have responded by isolating these underlying factors. Equity portfolios now offer targeted exposure to factors such as size, value, momentum, quality and low volatility.
There are three possible sources of return from investing in a factor over the long-term: fundamental, behavioural and structural. A fundamentally-driven return is earned for taking on higher risk. An example is the higher yield on offer from higher risk bonds. Behavioural returns are generated by strategies that profit from the predictable herd-like behaviour of the average investor. Structural returns are created when investors become forced buyers or sellers of securities because of the rules they operate under. These factors can be recombined in a way that improves diversification.
Quantitative analysis provides a wider dashboard of risk measures and techniques. These help investors understand the many dimensions of diversification.
The benefits (and limits) of diversification
Will Diversification 4.0 deliver advantages over the previous three models? To answer this, investors must first decide what they should expect from a diversified multi-asset portfolio. In particular, investors need to decide if they are diversifying to protect their portfolios against bad times. Or if they are looking for long-term returns from an expanded investment universe.
There are four assets that investors typically use to hedge portfolios against bad times. First, domestic government bonds can protect investors against the risks of deflation. Second, holding cash dampens portfolio volatility and gives investors the option to buy at lower prices during market setbacks. Third, gold typically performs well when the threat of inflation increases, or political uncertainty rises. Fourth, investors can purchase options whose value increases when the underlying asset falls in value.
These four strategies share one common feature: they reduce the long-term return potential of the portfolio. Government bonds and cash offer return premiums below equities and corporate bonds. Gold has historically been a store of value rather than a source of returns. Option strategies are a form of insurance. They deliver a positive expected return to the seller of the option rather than the buyer.
By contrast, a diversified portfolio of alternative assets can generate returns comparable to traditional risky assets: equities and corporate bonds. Greater diversity can bring greater certainty in returns over the long-term. A broader investment universe increases the possibility of identifying undervalued assets.
1A long-short strategy allows investors to profit from the relative performance of one security compared to another. It involves buying a security that is expected to outperform and selling the security expected to underperform. However, the investor does not hold the security being sold. In order to sell the security, the investor must first borrow it from another investor, for which the lender receives. This is a common hedge fund strategy. By contrast, long-only simply means buying a security.
What are the limits of diversification? Economically sensitive assets suffer simultaneously during recessions. Illiquid assets can be marked down when liquidity becomes scarce. Less economically sensitive assets can provide genuine diversification, but may come with other risks. A dynamic approach to asset allocation can reduce risk but increases reliance on manager skill. So too do some of the techniques adopted from hedge funds. Risk models provide an objective view of a portfolio’s risk exposures but achieving effective diversification requires judgement.
What is the future for diversification? We see six ongoing trends that are reshaping portfolio construction.
First, the shift from public to private markets is set to continue. The regulatory pressures for banks to increase their equity capital will continue to restrain bank lending. In addition, the nature of investment is changing. Technological advances are disrupting the economy, markets and employment. Investment in intangible assets now exceeds investment in tangible assets in the US and the UK. These investments involve greater uncertainty over the expected return. They are more readily financed by private equity than public markets.
Second, investors are integrating environmental, social and governance (ESG) analysis into their decision-making process. Understanding the risks and opportunities presented by ESG issues is a fundamental ingredient of investment, alongside traditional analysis.
Third, the developing world has enjoyed rapid economic progress over the past three decades. This means the ‘emerging market’ label no longer captures the whole story. Investors will need to embrace a more nuanced view. Emerging economies account for 60% of global activity. Yet their financial assets make up only 10% of the global financial system . These markets are increasingly opening up to foreigners. Asset owners will need to access the full range of investment opportunities to provide true diversification.
Fourth, advances in computer science will allow a more granular analysis of diversification. However, quantitative risk models will continue to have their limitations. A qualitative assessment of risk and return will remain vital to achieving effective diversification.
Fifth, regulatory regimes are modernising in many countries. This is exposing the mismatch of assets and liabilities of insurance companies and pension schemes. This is forcing asset owners to take a more sophisticated approach to risk management. How will regulation respond when the next crisis hits? History teaches us that the rules can change when systemically important financial institutions are under threat.
Sixth, individuals will increasingly have to take more responsibility for their own financial futures. Neither the state nor their employers will provide generous pensions. The asset management industry can help by providing the right tools, solutions and advice. These solutions must include making this broader range of investments accessible to all.
Increased diversification brings increased choice . Benefitting from a more diversified approach therefore requires skill and experience in order to assess this broader range of opportunities. This extra effort can be highly rewarding as, if done well, diversification can lead to improved long-term returns delivered in a smoother fashion. Not a free lunch perhaps, but definitely a healthy balanced diet.
iWilliam Goetzmann (2016). Money Changes Everything: How Finance Made Civilisation Possible.
iiCraig Turnbull (2018). 200 Years of Asset Allocation: Lessons From the Pioneers of Investing.
iiiMark Carney, Governor of the Bank of England (2018). New Economy, New Finance, New Bank.